Two and Twenty: Explanation of the Hedge Fund Fee Structure

What Is Two and Twenty?

Two and twenty (or "2 and 20") is a fee arrangement that is standard in the hedge fund industry and is also common in venture capital and private equity. Hedge fund management companies typically charge clients both a management and a performance fee. "Two" means 2% of assets under management (AUM), and refers to the annual management fee charged by the hedge fund for managing assets. "Twenty" refers to the standard performance or incentive fee of 20% of profits made by the fund above a certain predefined benchmark.

How Two and Twenty Works

The 2% management fee is paid to hedge fund managers regardless of the fund’s performance. A hedge fund manager with $1 billion AUM earns $20 million in management fees annually even if the fund performs poorly.

The 20% performance fee is charged if the fund achieves a level of performance that exceeds a certain base threshold known as the hurdle rate. The hurdle rate could either be a preset percentage or may be based on a benchmark such as the return on an equity or bond index.

Some hedge funds also have to contend with a high watermark that is applicable to their performance fee. A high watermark policy specifies that the fund manager will only be paid a percentage of the profits if the fund's net value exceeds its previous highest value.

This precludes the fund manager from being paid large sums for poor performance and ensures that any losses must be made up before performance fees are paid out.

Two and Twenty: Adding Up to Billions

The 10 highest-paid hedge fund managers collectively made $3.43 billion in fees in 2023. The table below shows the top five fund managers who raked in the most in 2023. Note that Jim Simons passed away in 2024.

The giant hedge funds founded by these fund titans grew so large that they generated hundreds of millions in management fees alone. Their successful strategies over many years—if not decades—have also earned these funds billions in performance fees.

While the steep fees charged by star hedge fund managers may be justified by their sustained outperformance, the billion-dollar question is whether the majority of fund managers generate sufficient returns to justify their two-and-twenty fee model.

Is Two and Twenty Justified?

Jim Simons, one of the highest-paid hedge fund managers until his passing in 2024, founded what would become Renaissance Technologies in 1978. An award-winning mathematician (and former NSA code breaker), Simons established Renaissance as a quant fund that employs sophisticated quantitative models and techniques in its trading strategies.

One of the world’s most successful hedge funds, Renaissance is best known for the tremendous returns generated by its flagship Medallion fund. Simons launched Medallion in 1988 and since then, it has generated an average annual return of about 40%.

Those returns are after Renaissance's management fees of 4% and performance fees of 44%. Medallion has been closed to outside investors since 1993, and currently only manages money for Renaissance employees.

Given the outsized returns Medallion has generated and how much it has beaten the market, it can be claimed that the fees charged justify the returns provided to investors.

However, such stellar performance tends to be the exception rather than the norm in the hedge fund industry. While hedge funds, by definition, are expected to make money in any market because of their ability to go long and short, their performance has lagged equity indices for years.

While for the trailing five years from 2017 to 2022, the top 50 hedge funds outperformed the S&P 500 by 3%, it has been generally proven that hedge funds do not outperform the market. Data shows that since 2011, hedge funds have consistently underperformed the S&P 500 every year.

Of course, there are all sorts of hedge funds focusing on different strategies, but data is consistent that hedge funds are "not reliable sources of absolute returns."

Warren Buffett, in his February 2017 letter to Berkshire Hathaway shareholders, estimated that the search by the financial "elite"—such as wealthy individuals, pension funds, and college endowments, all of whom tend to be typical hedge fund investors—for superior investment advice has caused it to waste more than $100 billion in aggregate over the past decade.

Loss of Favor

While hedge funds were popular once upon a time, investors have been pulling away due to a combination of the inability to outperform the market and the high fees. In 2023, investors pulled approximately $75 billion from hedge funds. In 2022, they pulled out $112 billion.

In November 2023, hedge funds had returned 5.7% for the year while the S&P 500 was up by around 24% in December 2023 for the year. In November 2024, the S&P 500 was up 25%. In comparison, by October 2024, hedge funds returned 7.67% for the year.

An Example of Two and Twenty 

Assume hypothetical hedge fund Peak-to-Trough Investments (PTI) had $1 billion in AUM at the beginning of Year 1, and is closed to investors. The fund's AUM grows to $1.15 billion at the end of Year 1, but by the end of Year 2, AUM falls to $920 million, before rebounding to $1.25 billion by the end of Year 3. If the fund charges the standard "two and twenty," the total annual fees earned by the fund at the end of each year can be calculated as follows:

Year 1:

Fund AUM at beginning of Year 1 = $1 billion

Fund AUM at end of Year 1 = $1.15 billion

Management fee = 2% of year-end AUM = $23 million

Performance fee = 20% of fund growth = $150 million x 20% = $30 million

Total fund fees = $23 million +$30 million = $53 million

Year 2:

Fund AUM at beginning of Year 2 = $1.15 billion

Fund AUM at end of Year 2 = $920 million

Management fee = 2% of year-end AUM = $18.4 million

Performance fee = Not payable as high watermark of $1.15 billion has not been exceeded

Total fund fees = $18.4 million

Year 3:

Fund AUM at beginning of Year 3 = $920 million

Fund AUM at end of Year 3 = $1.25 billion

Management fee = 2% of year-end AUM = $25 million

Performance fee = 20% of fund growth above high watermark = $100 million x 20% = $20 million

Total fund fees = $25 million +$20 million = $45 million

The Bottom Line

Hedge funds are investment vehicles for accredited investors and financial institutions. Hedge funds seek to utilize unique strategies to generate alpha: beating the returns of the market. For their services, hedge funds charge two fees: a management fee, which is generally 2% of assets under management, and a performance fee, which is usually 20% of fund growth.

These high fees are believed to be justified given the high returns that hedge funds are meant to generate for their investors; however, data has shown that hedge funds rarely beat the market and more often than not, the S&P 500 outperforms them. The combination of lackluster returns and high fees has resulted in outflows of investor money from hedge funds.